Monday, January 6, 2020

Can passive funds lead to wealth erosion?

In the first part of this note, we dealt with the nuances that passive funds introduce to the investment market and why they are preferred by institutional investors. We also discussed why incentives for individual investors differ from those of institutions and the contention that lower costs ensure better performance is a fallacious one.

In this part of the note, we discuss the factors which contribute to relative performance and the role that ETFs can play in the portfolios of different categories of individual investors.

The relative performance of an actively managed fund vis-à-vis the index depends largely on the constitution on the index itself and the performance of choices made by the fund manager. For example, as of December 8, 2019 the weight of Reliance Industries and HDFC Bank in the BSE Sensex is 12.42% and 12.00% respectively. In contrast, no actively managed fund can invest more than 10% of its portfolio in any single stock. Therefore, all actively managed funds are under-weight these two stocks because of the composition of the index itself.

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This note was published on on January 4, 2020

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